Essentials of Economics

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Essentials of Economics

• Business 502

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Money and Interest

• We have seen that extending the Keynesian
  income-expenditure model to take account of the
  impact and interrelationship of money and
  interest rates helps us to understand the impact
  of the price level on aggregate demand.
• We will find that it also helps with policy.

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Aggregate Demand and the Price Level
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Some Details

• an increase in the price level reduces the
  purchasing power of the fixed money supply.
• with less purchasing power, people are less able
  to reduce their shoe leather costs of carrying
  out business transactions, and they demand more
  money for transactions.
• investors need more money to finance the same
  projects as before, increasing the demand for
  loans.
• both of these influences tend to increase the
  interest rate.

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Monetary Policy

• Monetary Policy
• Changes in central bank policy or in bank
  reserves, designed to influence the interest rate
  and thus investment, production and employment,
  are called monetary policy.
• Monetary policy will have its influence (mainly)
  through the effect on interest rates and
  therefore on investment (details to follow).

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Monetary Policy
Interest is at the center of monetary policy.
Suppose that the Federal Reserve System wants to
stimulate more aggregate demand. They buy bonds,
increasing the money supply. There is more
purchasing power at every price level, so the
aggregate demand curve shifts to the right. If
the Fed wants to reduce the aggregate demand, to
offset inflation by holding the price level down,
they withdraw money from the economy (selling
bonds) and that would lead to a shift to the left
in the AD curve.
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The Marginal Efficiency of Investment

• Marginal Efficiency of Investment
• The Marginal Efficiency of Investment is a
  relationship between interest and investment that
  tells us, for each respective interest rate, the
  amount of investment that can be undertaken
  profitably, ceteris paribus.
• Abbreviation MEI

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What Determines Interest?
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Policy

• Suppose that the rate of interest is Rb, the
  money supply is Mb, and the Federal Reserve
  authorities want to raise the interest rate to
  Ra. They would do this by cutting the money
  supply back to Ma.
• Suppose that the rate of interest is Ra, the
  money supply is Ma, and the Federal Reserve
  authorities want to reduce the interest rate to
  Rb. They would do this by increasing the money
  supply to Mb.
• These two examples illustrate "interest rate
  targeting."

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Reducing the Money Supply
Cut the money supply back to Ma. At the going
interest rate of Rb, people would want to hold
more money than that, so they would sell some of
their bonds to get more money. But with no more
money to be gotten, their competition to sell
bonds would just push the price of bonds down and
the interest rate up. Thus the interest rate
would rise to Ra, and at that rate, people would
be satisfied to hold the reduced supply of money
and would not compete to sell any more bonds at
even lower prices.
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Increasing the Money Supply
Increase the money supply to Mb. At the going
interest rate of Ra, people would want to hold
more bonds, so they would compete to buy bonds
with their increased money balances. But with no
more bonds to be gotten, their competition to buy
bonds would just push the price of bonds up and
the interest rate down. Thus the interest rate
would drop to Rb, and at that rate, people would
be satisfied to hold the increased supply of
money and would not compete to sell any more
bonds at even higher prices.
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A Complication The Liquidity Trap
In this figure there is a liquidity trap at Rt
-- the FED cannot force the interest rate below
Rt. In May, the FED estimated that the interest
rate target for an optimal monetary policy would
be -5 -- and it is certain that the interest
rate in this sense cannot go below zero!
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Recently,
Because of the credit crisis last fall, it seems
almost certain that we had a liquidity trap at
a positive interest rate at that time. In any
case, there is always a liquidity trap at zero
interest.
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From the General Theory

• If the Treasury were to fill old bottles with
  banknotes, bury them at suitable depths in
  disused coalmines which are then filled up to the
  surface with town rubbish, and leave it to
  private enterprise on well-tried principles of
  laissez-faire to dig the notes up again (the
  right to do so being obtained, of course, by
  tendering for leases of the note-bearing
  territory), there need be no more unemployment

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Inflation

• This quote from Keynes will give many economists
  the heebie-jeebies.
• In many historical cases, such wholesale creation
  of money has led to inflation and hyperinflation.
  
• On the contrary, many economists would argue that
  the first aim of monetary policy should be the
  prevention of inflation.

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Causes

• When demand increases and this results in
  inflation, we describe it as demand pull
  inflation.
• When cost increases and this causes supply to
  decrease in turn, and this results in inflation,
  we describe it as cost push inflation.
• They may reinforce one another.

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Why does it matter how many zeros we have on our
bills?

• Inflation
• Creates uncertainty, in that people do not know
  what the money they earn today will buy tomorrow.
• Uncertainty, in turn, discourages productive
  activity, saving and investing.
• Reduces the competitiveness of the country in
  international trade.

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Inflation as a Problem, Contd.

• Inflation is a hidden tax on "nominal balances."
  That is, people who hold bonds and bank accounts
  in dollars lose the value of those accounts when
  the price level rises, just as if their money had
  been taxed away.
• The inflation tax is capricious -- some lose by
  it and some do not without any good economic
  reason.
• As the purchasing power of the monetary unit
  becomes less predictable, people resort to other
  means to carry out their business, means which
  use up resources and are inefficient.

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Hyperinflation
The term "hyperinflation" refers to a very rapid,
very large increase in the price level. In
Germany, for example, between January 1922 and
November 1923 (less than two years!) the average
price level increased about 20 billion times.
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German Hyperinflation 1
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German Hyperinflation 2
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German Hyperinflation 3
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Interim Summary

• Clearly, inflation can be a problem.
  Hyperinflation means no less than the breakdown
  of the economic system.
• Less drastic inflations create less drastic
  problems. The problems arise largely from the
  uncertainty and distortions of resource use that
  are associated with inflation.

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Interest Rate Targeting

• Most modern economists would argue that the
  primary job of monetary policy is to prevent
  inflation. (That view is less popular since the
  fall of 2008.)
• The key method of modern monetary policy is
  interest rate targeting.
• The interest rate that matters is the real
  interest rate -- adjusted for inflation, again.

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Interest Rates
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But!

• We should adjust interest rates for inflation.
• Because inflation reduces the purchasing power of
  the lenders principle amount, in proportion to
  the inflation rate, and
• Because inflation reduces the repayment burden on
  the borrower, in purchasing power terms, just in
  the same proportion.

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Inflation
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Adjusting for Inflation
We see that the rate of inflation (in terms of
the consumer price index) has varied widely over
the period. To adjust for inflation, we compute
the real interest rate by subtracting the rate
of inflation from the rate of interest.
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Real Interest
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Fiscal Policy
An increase in government spending, ceteris
paribus, will shift aggregate demand to the
right, and a decrease in government spending will
shift it to the left. Changes in taxes would also
influence aggregate demand, according to the
Keynesian approach, although with somewhat less
impact, dollar for dollar. An increase in taxes
would shift the aggregate demand curve to the
left, and a tax cut would shift it to the right.
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Government Purchases
Replace Y CI with Y CIG G is government
purchases of goods and services. We will treat it
as a component of autonomous spending.
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Equilibrium with Government Purchases
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Fiscal Policy a First Approach
What we have just seen is that a change in
government purchases of goods and services can
influence the equilibrium income in the model
economy. An increase in income would mean
(ceteris paribus) that more people would be
employed to produce the income. So it could make
sense for the government to spend more money in
order to stimulate production. Public works
projects designed to increase employment would be
an example of "fiscal policy."
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What about Taxes?
We will have to distinguish between income before
and after taxes. Disposable Income Disposable
income is income net of taxes, and is the income
the individual is able to divide between
consumption and spending. C a b(Yd) a
b(Y-T)
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Equilibrium with Taxes
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Multipliers 1
With government spending but no taxes,
equilibrium income can be expressed by the
multiplier formula
where a is the part of consumption that does not
depend on income, the autonomous consumption,
and b is the marginal propensity to consume,
i.e. the additional consumption consequent on 1
more income.
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Multipliers 2
With taxes, the multiplier formula is more
complex
where G is government spending and T is taxation.
Notice that a 1 increase in G and T, a balanced
budget expansion, will not exactly offset. On
net, taxes have less impact than spending.
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Two Sides of Fiscal Policy

• Recessionary Gaps
• A recessionary gap exists when production is less
  than full employment production. It might also be
  called a "contractionary" gap, since production
  is "contracted" below full employment.
• Inflationary Gaps.
• An inflationary gap exists when equilibrium
  income is greater than full employment income. An
  inflationary gap could also be called an
  expansionary gap.

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Approaches to Fiscal Policy

• Discretionary fiscal policy
• This means the government changes taxes and
  spending to respond to current events
• However, lags in the legislative process make
  this a questionable Rx in most circumstances
• Automatic stabilizers
• Progressive taxes, unemployment insurance and
  similar government programs are automatically
  stimulating in recessions.

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Crowding Out

• Another criticism of fiscal policy is that
  government spending may crowd out other forms
  of spending, especially investment.
• This would reduce the effectiveness of fiscal
  policy
• Especially as we approach full employment.

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A Guide to Fiscal Policy 1

• Recall the paradox of thrift. The idea is that
• At full employment people would want to save more
  than can be invested.
• Cutting back on their spending, they reduce
  aggregate demand.
• This leads to a decline in employment and income,
  
• which reduces planned spending to the level of
  investment.
• A fiscal policy to limit the decline in
  production and employment substitutes government
  spending, usually at a deficit, for the
  private-sector spending that has declined.

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A Guide to Fiscal Policy 2

• This would function through the multiplier.
• Recall, a dollar of government spending has a
  multiplier of 1/(1-MPC)
• A tax or tax cut has a negative multiplier of
  MPC/(1-MPC)
• All of this assumes that the increase in
  government debt can take place without a
  consequent rise in the interest rate. Interest
  rates might rise for two reasons
• People might fear default or inflation because of
  the increase in debt.
• Government debt might have to compete with, and
  crowd out, private debt.

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A Guide to Fiscal Policy 3

• In late 2008 and early 2009, there was
  controversy about which forms of fiscal policy
  would have the greatest immediate effect.
• Conservatives tended to support tax cuts.
• We have seen that they have a smaller multiplier,
  and have little or no impact at all unless they
  are permanent. (This follows from the ideas of
  Friedman and Modigliani and is illustrated by
  Johnson and G. W. Bush tax cuts).
• However, conservatives argued that the impact
  would be immediate, while it would take time for
  public spending projects to get going.

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A Guide to Fiscal Policy 4

• While highway work might be needed (some
  conservatives argued) a recession would be the
  wrong period because we cant afford it.
• Liberals tended to support public works.
• The larger multiplier was one reason.
• It was argued that the impact on jobs would be
  more certain -- we never really know whether a
  tax cut will be spent or not, and if not, no
  jobs.
• Recession would be the best time, since private
  investment would not be crowded out.

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A Guide to Fiscal Policy 5

• This point was not made in the discussion, but
  the expectation that public works would continue
  to create jobs over some period in the future
  would improve peoples perception of their future
  permanent or life cycle income and thus
  stimulate their consumption today.
• Once again, either position requires us to assume
  that there is no danger either of default or
  inflationary finance to repay the public debt --
  that we can grow our way out of it. This is no
  less true of tax cuts than of public works.

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Fiscal Policy Summary

• Government spending is incorporated in the
  income-expenditure model as an additional
  component of autonomous spending.
• This is the basis for analysis of fiscal policy.
• With taxes in the picture, we relate consumption
  to disposable income.
• For that reason, tax changes are somewhat less
  effective (all in all) than spending changes.